Trading Options 101

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Equity options are fairly simple investment instruments. Basically, an option is a contract. Still, trading options is considered something for the experienced, knowledgeable investor, because it is easy to create unintended consequences with options. Purchasing an option it does not obligate you to buy or sell the underlying stock, but your broker may automatically exercise the option at expiration under certain conditions. When trading options, you must pay close attention to the underlying stock and market conditions for your option positions --- especially when near their expiration date.

Call Options

  • A call option gives its owner the right to buy shares of the underlying stock at the strike price. The expiration date is the date on which this right expires. At expiration, it is common for a brokerage to automatically exercise in-the-money call options, which results in your purchasing the corresponding amount of stock. A call option is "in-the-money" when the underlying stock is worth more than the option's strike price. Options traders generally sell a profitable option back into the market prior to expiration, unless they specifically want the option to be exercised. For speculation, a trader would buy a call option if they expect the price of the underlying stock to increase.

Put Options

  • A put option gives its owner the right to sell shares of the underlying stock at the strike price. A put option is the inverse of a call option. When the underlying stock goes down, a put option normally increases in value. A trader would buy a put option if they expect the underlying stock to go down. Therefore, a put option is "in-the-money" when the underlying stock is worth less than the option's strike price. It is also important to understand your broker's policies regarding put options at expiration. Besides speculation, buying a put option can be used as short-term protection for a stock position.

American and European-Style Options

  • Most options traded on U.S. exchanges are American-style. American-style options can be exercised any time prior to expiration. European options can only be exercised at expiration. Keep in mind that the holder is the one who has the rights, and the writer is the one who gives the rights. Therefore, if you write options, the options can be exercised by the other person. Sometimes an investor will write call options on stock they own in an attempt to increase return. This strategy is referred to as "selling covered calls."

Based on Round Lots

  • An option contract is usually based on 100 shares of stock, or a "round lot." Movements in the underlying stock can have a huge effect on the value of the options. That's because options are a leveraged type of investment when compared to investing the same dollar amount directly in the underlying stock. How much an option moves in relationship to a movement in the underlying stock is referred to as the option's "delta."

Order Types

  • There are four basic order types for equity options: buy to open, buy to close, sell to open and sell to close. A "buy to open" is simply the purchase of an option. Conversely, "sell to close" is the selling of a held option position. "Sell to open" gets a bit more sophisticated, since it refers to writing an option --- you are the promising party. Conversely, a "buy to close" is an offsetting purchase to close out outstanding option obligations. You could close out your outstanding covered calls by buying the same calls. Because the options market is a regulated market, one obligation is considered just as good as another.

Option Combinations

  • Combinations, spreads and other terms basically refer to combining two or more of the four basic order types to offset risk and reduce cash outlay. Perhaps the simplest of spreads is the vertical spread. This involves buying and selling two of the same type and expiration options with different strike prices. This helps offset the price of the overall transaction, lowering the amount of cash at risk. The downside of such a strategy, and combinations in general, is that they can cap the amount of profit potential. Still, trading professionals often use spreads, basing their choices on their projected risk versus reward.

Time Decay

  • Options have a time value. For example, if two call options have the same strike price but different expiration dates, the one with the furthest date would cost more. The theory is that there's a better chance the price will move in your favor with a longer time period for it to do so. Therefore, an options trader must not only choose the price direction correctly, but have the timing correct as well. Otherwise, an option that is "out-of-money" can expire worthless. Out-of-the-money means there is no value in exercising the option at the strike price; you would be better off buying, or selling, the stock outright.

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